While the effects of climate change are severe and interconnected, collaboration among global stakeholders is growing to lessen its effects, and that can only be positive. In the financial sector, the best-kept secret may be a relatively young asset class known as catastrophe bonds.
Catastrophe bonds (or “cat bonds”), which mark their 25th anniversary as an asset class this year, were created to diversify risk for insurers and increase coverage after the dual disasters of Florida’s Hurricane Andrew and California’s Northridge earthquake. The effect on the entire insurance industry could have been disastrous if Andrew had hit just 25 miles south in the city of Miami. Some might assume the insurance industry could have achieved sufficient insulation from too much loss through the use of reinsurance (i.e., the insurance of insurance by specialized players) and retrocessional insurance (that’s the insurance of insurance of, yes, insurance). Those tools helped, and in many cases still do, effectively. But in a time of increasingly severe weather events, an even deeper level of protection is necessary. As a result, cat bonds have become increasingly popular.
Last year, the insurance industry faced $343 billion in climate-related catastrophic losses, making it the third costliest year on record. The differential between economic losses and insured losses (aka the “protection gap”) was 62 percent. In total, there were over 400 environmental disasters—fewer than in 2020 but they were generally more extreme and more expensive. Also in 2021, Death Valley in California experienced the highest temperature on Earth ever recorded. Cat bonds meet the moment by transferring insurance risk to the wider capital market, which can absorb exponentially more losses.
The structures of this insurance-linked security (ILS) are sophisticated, and Aon, a leading global professional services firm, is leading the way. Says Paul Schultz, the CEO of Aon Securities, the largest structurer of catastrophe bonds, which, since the market’s inception in 1997, has provided its services to clients in 39% of all issuances: “We spend a lot of our time talking to and educating the markets about catastrophe bonds.”
So here’s how they operate, in relatively simple terms: Working with institutional clients, for the most part (deals typically start around $100 million) Aon and other structuring agents act as an investment bank in the transaction. They collaborate with clients to create a Special Purpose Vehicle, or SPV, that issues the bond, to develop the structure of the bond—which specifies which risks, whether hurricanes, earthquakes, floods et al., are covered—–and to determine how they will place it in the marketplace. Then, they communicate with investors to complete the deal. During the term of such bonds, usually three years, the funds are kept in a dedicated account. If the insured catastrophic event occurs, the money goes toward covering losses. If it doesn’t, investors get it back with interest attached. There are roughly three types of “triggers” for payouts: “indemnity,” which is closely aligned with actual losses incurred by the transaction’s sponsoring insurance company or insured; “industry loss,” which is similar to indemnity but aligned with losses incurred by the insurance industry as a whole; and “parametric,” which is based on a catastrophe’s physical characteristics, like a windstorm that occurs within a certain number of miles from a particular city, at a particular velocity. Those on both sides of the transaction like such vehicles because they have low correlation to financial markets, offering diversification from other types of investments, and historically they’ve offered better returns than conventional high-yield bonds.
To keep this investment as safe as possible both for protection buyers and for investors, sound analytical methods to calculate risk are necessary. And in the case of cat bonds, these are again novel. The traditional insurance industry credo that the-past-is-the-best-predictor-of-the-future isn’t as applicable when so little historical data exists for the kind of increasingly severe weather and climate events that were previously considered rare. Floods are one example. For perils that have data quality issues, there are non-indemnity triggers (i.e. parametric and index based solutions) that can help fill the gap. Predictive forward-looking modeling, which uses thousands of data points to assess a catastrophe’s probability and cost, is also key to helping shape better decisions. Aon is also a leader on this front.
Schultz notes that his division uses multiple commercial modeling types but that Aon also has its own “Impact Forecasting” team, a catastrophe modeling center of excellence that can help create a “better and a tighter fit for clients than you could if you relied on one single data point.” Aon, which advised on over half of the cat bonds issued last year, also has a strategic alliance with artificial intelligence and machine learning company Zesty.ai to develop first-of-their-kind models for severe convective storms and floods.
Among Aon’s clients is Arch Capital Group, which worked with the firm to structure a $150 million deal that covered a wide range of catastrophe types globally—and was Arch’s first such bond in the property arena. Emmanuel Durousseau, head of retrocession and ILS at Arch Reinsurance, says, “This deal is a good complement to our overall strategy. The multi-peril, multi-region and multi-year aspects make it more capital intensive for traditional solutions, which are subject to the annual fluctuations of their market. This is where ILS can bring value to the overall picture. The cat bond allows some syndication by delivering size that would have been constrained under a private structure.”
Commenting on Aon and its role in the deal, Durousseau says, “From a sponsor point of view, as the structuring agent and bookrunner, Aon brings knowledge, market relationships, and a global presence within the investor community.”
Some might ask, in the event of a significant climate event, how would this burgeoning asset class fare? “Hurricane Katrina is actually a good example of how the market expanded after a catastrophic event,” says Aon’s Schultz. “The market was still pretty small [before it] and the traditional insurance markets and reinsurance markets couldn’t provide enough capacity for all those that were looking to hedge hurricane risk in the U.S.” Cat bonds quickly grew to a $14 billion market and that growth has continued. A landmark $12.5 billion in cat bonds was issued in 2021, and there are now $32 billion of active cat bonds in the market.
When it comes to future development and trends, Schultz highlights opportunities for social impact, via relationships with governments, humanitarian organizations, and academic institutions. Aon has worked with the World Bank on several deals including the largest ever cat bond covering earthquakes, in Chile, Colombia, Mexico and Peru, and another covering tropical cyclones that was sponsored by Jamaica—the first sponsored by a Caribbean country. The World Bank’s participation in issuing cat bonds highlights the fact that cat bonds are beneficial to governments and countries as well. By transferring the risk of natural disasters, countries improve their economic resilience and have greater access to capital to provide disaster relief to their citizens if an extreme weather event does occur. Particularly for underserved and emerging markets, cat bonds can offer an important economic lifeline.
Such structures are also groundbreaking because they allow investors across the globe to support economically disadvantaged countries, while potentially strengthening individual stakeholders and the broader industry as well. “We want to grow the entire market,” Schultz sums up. “But we also want to maximize the social impact from these transactions.”